Managerial Economics

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Transcript of Managerial Economics

Chapter 8: Production and Cost in the short runA manager must produce with some inputs that are fixed in quantity. The manager has a fixed amount of plant and equipment with wich to produce the firms's output.Chapter 9: Production and Cost in the long runChapter 11: Managerial Decisions in competitive marketsHow do managers make price and output decisions to maximize the profit of the firm?- Taking into account:Chapter 12: Managerial Decisions for firms with market powerManagerial EconomicsFoundations of businessanalysis and strategyChristopher Thomas, S. Charles Maurice 11th editionPresented by: JORGE SÁNCHEZFebruary 01st, 2014Chapter 13: Strategic Decision Making in Oligopoly MarketsSuccessful managers must learn how to anticipate the actions and reactions of other firms in the market.General conceptsInputs in production:

* Production periods:- Short run:- Long run:Kinds of production* Variable proportions production: production in wich a given level of output can be produced with more than one combination of inputs.* Fixed proportions production: production in which one, and only one ratio of inputs can be used to produce a good.ProductionCreation of goods and services from inputs or resources.Production functionSchedule showing the maximum amount of output that can be produced from any specified set of inputs, given the existing technology.Inputs- Variable input: level of usage may be varied to increase or decrease output.- Fixed input: level of usage can not be changed and it must be paid even if no output is produced.- Quasi-fixed input: lumpy or indivisible input for which a fixed amount must be used for any positive level of output, and none is purchased when output is zero.EfficiencyEconomic efficiencyProducing a given level of output at the lowest-possible total cost.Technical efficiencyProducing the maximum output for any given combination of inputs and existing technology.CostsAvoidable costPayment for an input that a firm can recover or avoid paying should the firm no longer wish to use that input. Variable costs and quasi-fixed costs are avoidable costs.Sunk costPayment for an input that, once made, cannot be recovered should the firm no longer wish to employ that input. Fixed costs are sunk costs.Operating and planning periods201420152019Short run Production Period(Operating horizon)Current time span during which at least one input is a fixed input and must be paid whether or not any output is produced.Long run production period(Planning horizon)Time period for enough in the future to allow all fixed inputs to become variable inputs. Thus, the set of all possible short-run situations the firm can face in the future.Production in the short runAverage and Marginal ProductsAverage product of labor (AP):Short-run costs of productionTotal CostTotal fixed cost (TFC): Total amount paid for fixed inputs. It does not vary with output.Total variable cost (TVC): Total amount paid for variable inputs. It increases with increases in output.Total cost (TC):TC = TVC + TFCAverage and Marginal CostsProduction functionOnce level of capital (K) is fixed, the only way the firm can change its output is by changing the amount of labor (L) it employs.Marginal product of labor (MP):When:AP rises, MP > APAP falls, MP < APAP reaches its maximum, AP = MPAs the number of units of the variable input increases, other inputs held constant, a point will be reached beyond which its marginal product decreases.Law of diminishing marginal productChanges in Fixed InputsAverage fixed cost (AFC):Average variable cost (AVC):Average total cost (ATC):Short-run marginal cost (SMC):Relations:(1) AFC declines continuously, approaching both axes asymptotically.(2) AVC first declines, reaches a minimum at Q2, and rises thereafter. When AVC is at its minimum, SMC equals AVC.(3) ATC first declines, reaches a minimum at Q3, and rises thereafter. When ATC is at its minimum, SMC equals ATC.(4) SMC first declines, reaches a minimum at Q1, and rises thereafter. SMC equals both AVC and ATC when these curves are at their minimum values.* SMC lies below both AVC and ATC over the range for which these curves decline.* SMC lies above them when they are rising.RelationsTotal Variable Cost (TVC):

Total Fixed Cost (TFC):

Total Cost (TC):

Average Variable Cost(AVC):

Short-run Marginal Cost (SMC):w: price of a unit of labor servicesr: price of a unit of capital services• When marginal product (average product) is increasing, marginal cost (AVC) is decreasing.• When marginal product (average product) is decreasing, marginal cost (AVC) is increasing.• When marginal product equals average product at maximum AP, marginal cost equals minimum AVC.Production IsoquantsAll inputs are variable in the long run. A curve showing all possible combinations of inputs physically capable of producing a given fixed level of output. It shows how one input can be substituted for another while keeping the level of output constant.Marginal rate of technical substitution (MRTS)Slope of an isoquant that measures the rate at which one input is substituted for another along an isoquant.The minus sign is added to make MRTS a positive number, since ∆K / ∆L, the slope of the isoquant, is negative.Isocost curves Line that shows the various combinations of inputs that may be purchased for a given level of expenditure (C) at given input prices (w, r).Optimal combination of inputsTo producing a given level of output at the lowest possible cost when two inputs (L and K) are variable and the prices of the inputs are, respectively, w and r, a manager chooses the combination of inputs for which:which implies that:Production of a given output at minimum costIn the case of two variable inputs, labor and capital, the manager of the firm maximizes output for a given level of cost by using the amounts of labor and capital such that the marginal rate of technical substitution (MRTS) equals the input prices ratio (w/r).which implies that:Production of maximum output with a given level of costOptimization and costThe expansion path is the curve along which a firm expands (or contracts) output when input prices remain constant. Each point on the expansion path represents an efficient (least-cost) input combination. Along the expansion path, the marginal rate of technical substitution equals the constant input price ratio. Also, it indicates how input usage changes when output or cost changes.Long-run costsLong-run total cost:

Long-run average cost:

Long-run marginal cost:w & r: prices of labor & capital, respectively; (L*, K*): input combination on the expansion path that minimizes LTC of producing that output.Forces affecting long-run costEconomies and diseconomies of scaleEconomies of scale: occurs when long-run average cost (LAC) falls as output increases.Diseconomies of scale: occurs when long-run average cost (LAC) rises as output increases.Reasons1. Larger-scale firms have greater opportunities for specialization and division of labor.2. Scale economies also arise when quasi-fixed costs are spread over more units of output causing LAC to fall.3. A variety of technological factors can also contribute to falling LAC.Constant CostsNeither economies or diseconomies of scale occur, thus LAC is flat and equal to LMC at all output levels.Minimum efficient scaleLowest level of output needed to reach minimum long-run average cost.Economies of ScopeExist for a multi-product firm when the joint cost of producing two or more goods is less than the sum of the separate costs of producing the goods:Firms that already produce good X can add production of good Y at lower cost than a specialized, single-product firm can produce Y:Joint productsWhen production of good X causes one or more other goods to be produced as byproducts at little or no additional cost.Reasons that give rise to economies of scopeCommon orshared inputsInputs that contribute to the production of two or more goods or services.Purchasing Economies of ScaleLarge buyers of inputs receive lower input prices through quantity discounts, causing LAC to shift downward at the point of discount.Learning of Experience Economies“Learning by doing” or “Learning through experience”As total cumulative output increases, learning or experience economies cause long-run average cost to fall at every output level.Relations between short-run and long-run costs* LMC intersects LAC when the latter is at its minimum point.* At each output where a particular ATC is tangent to LAC, the relevant SMC = LMC.* For all ATC curves, point of tangency with LAC is at an output less (greater) than the output of minimum ATC if the tangency is at an output less (greater) than that associated with minimum LAC.Long-run Average Cost (LAC) as the Planning HorizonRestructuring Short-run CostsIt can be achieved by adjusting plant size to the level that is optimal for the new output level, as soon as the next opportunity for a long-run adjustment arises. It can be easy to understand with a short-run expansion path.Short-run expansion path:Horizontal line showing the cost-minimizing input combinations for various output levels when capital is fixed in the short run.Perfect competitionA market structure that exists when:(1) Firms are price-takers.(2) All firms produce a homogeneous product.(3) Entry and exit are unrestricted.Demand facing a price-taking firmDemand curve facing a competitive price-taking firm is horizontal or perfectly elastic at the price determined by the intersection of the market demand and supply curves. Since marginal revenue equals price for a competitive firm, the demand curve is also simultaneously th marginal revenue (D = MR). Price-taking firms can sell they want at the market price. Each additional unit of sales adds to total revenue an amount equal to price.Profit maximization in the short runA manager must take two decisions during the period:ProduceShut downZero output in the short run but must still pay for fixed inputs.What is the optimal level of output?- There are two output decisions:Managers can not maximize both profit and profit margin at the same level of output. For this reason, profit margin (or average profit), should be ignored when making profit-maximizing decisions. When a firm can make positive profit in the short run, profit is maximized at the output level where MR (=P) =SMC.Earning positive economic profit (π)Operating at a Loss or Shutting downThe manager of the firm will choose to produce the output where P = SMC, rather than shut down, as long as total revenue is greater than or equal to the firm's total avoidable cost or total variable cost (TR >= TVC). Or, equivalently, a firm should produce as long as price is greater than or equal to average variable cost (P >= AVC). If total revenue can not cover total avoidable cost, that is, if total revenue is less than total variable cost (or, equivalently, P < AVC), the manager will shut down and produce nothing, losing an amount equal to total fixed cost.Short-run supply for the firm and industryThe short-run supply curve for an individual price-taking firm is the portion of the firm's marginal cost curve above minimum average variable cost. For market prices less than minimum average variable cost, quantity supplied is zero. The short-run supply curve for a competitive industry can be obtained by horizontally summing the supply curves of all the individual firms in the industry. Short-run industry supply is always upward-sloping, and supply prices along the industry supply curve give the marginal costs of production for every firm contributing to industry supply.Producer Surplus and Profit in Short-run competitive equilibriumShort-run producer surplus is the amount by which total revenue exceeds total variable cost and equals the area above the short-run supply curve below market price over the range of output supplied. Short-run producer surplus exceeds economic profit by the amount of total fixed costs.Profit maximization in the long runProfit-maximizing equilibrium for the firmIn long-run competitive equilibrium, all firms are maximizing profit (P = LMC), and there is no incentive for firms to enter or exit the industry because economic profit is zero (P = LAC). Occurs because of the entry of new firms into the industry or the exit of existing firms from the industry. The market adjusts so that P = LMC = LAC, which is at the minimum point on LAC.Long-run supply for a perfectly competitive industryIn an constant-cost industryInput prices remain constant as all firms in the industry expand output.In an increasing-cost industryInput prices rise as all firms in the industry expand output.Economic rent and producer surplus in long-run equilibriumFirms that employ exceptionally productive resources earn zero economic profit in long-run competitive equilibrium because the potential economic profit form employing a superior resource is paid to the resource owner as economic rent. In increasing-cost industries, all long-run producer surplus is paid to resource suppliers as economic rent.Profit-maximizing input usageProfit-maximizing level of input usage produces exactly that level of output that maximizes profit.Marginal revenue product Additional revenue earned when the firm hires one more unit of the input.If the MRP of an additional unit of a variable input is grater than the price of that input, that unit should be hired. If the MRP of an additional unit adds less than its price, that unit should not be hired. If the usage of the variable input varies continuously, the manager should employ the amount of the input at which MRP = Input price.Average revenue product Average revenue per workerIf the price of a single variable input employed by a competitive firm rises above the point of maximum ARP (= P * AP), then the firm minimizes its loss by shutting down and hiring none of the variable input.Implementing the profit-maximizing output decisionGeneral rules of implementationThen:So:Ability possessed by all price-setting firms to raise price without losing all its sales, which causes the price-setting firm's demand to be downward-sloping.MonopolyA firm that produces a good for which there are no close substitutes in a market that other firms are prevented from entering because of a barrier to entry.Monopolistic competitionA market consisting of a large number of firms selling a differentiated product with low barriers to entry.Measurement of the market powerIdentifies producers and products that compete for consumers in a particular geographic area.Elasticity of DemandCross-price Elasticity of DemandLerner IndexA ratio that measures the proportionate amount by which price exceeds marginal cost.E: price elasticity of demandBarriers to entryCondition that makes it difficult for new firms to enter a market in which economic profits are being earned. The most structural entry barriers are:- Economies of Scale- Barriers created by Government- Essential Input Barriers- Brand Loyalties- Consumer Lock-In- Network Externalities (Network effects)- Sunk Costs as a General Barrier to EntryProfit maximization under monopolyA monopolist chooses the point on the market demand curve that maximizes profit. If marginal revenue exceeds marginal cost, a profit-maximizing monopolist increases output. If marginal revenue is less than marginal cost, the monopolist does not produce these additional units. Demand and Marginal Revenue for a MonopolistThe market demand curve is the demand curve for the monopolist. Because the monopolist must lower price in order to sell additional units of output, marginal revenue is less than price for all but the first unit sold of output sold. When MR is positive (negative), demand is elastic (inelastic). For a linear market demand, the monopolist's MR is also linear, with the same vertical intercept as demand, and is twice as steep.Short-run Equilibrium: Profit Maximization or Loss MinimizationThe manager of a monopoly firm will choose to produce the output where MR = SMC, rather than shut down, as long as TR at least covers the firm’s total avoidable cost which is the firm's total variable cost (TR ≥ TVC). The price for that output is given by the demand curve. If TR can not cover total avoidable cost, that is, TR < TVC (or, equivalently, P < AVC) the manager will shut down and produce nothing , losing an amount equal to total fixed cost. If P > ATC, firm makes economic profit. If ATC > P > AVC, firm incurs a loss, but continues to produce in short run.Long-run EquilibriumMonopolist maximizes profit in the long-run by choosing to produce the level of output where MR = LMC, unless P < LAC, in which case the firm exits the industry. Monopolist will adjust plant size to the optimal level; that is, the optimal plant is the one with the short-run average cost curve tangent to the long-run average cost at the profit-maximizing output level.Profit-maximizing input usageProfit-maximizing level of input usage produces exactly that level of output that maximizes profit.Marginal revenue productAdditional revenue attributable to hiring one additional unit of the input, which is also equal to:* When producing with a single variable input:- Employ amount of input for which MRP = input price.- Relevant range of MRP curve is downward sloping, positive portion, for which ARP > MRP.* For a firm with market power, profit-maximizing conditions MRP = w and MR = MC are equivalent.- Whether Q or L is chosen to maximize profit, resulting levels of input usage, output, price and profit are the same.Monopolistic competitionLarge number of relatively small firms.Products that are similar to, but somewhat different from, one another.Unrestricted entry and exit of firms into and out of the market.Short-run EquilibriumWith a given demand, marginal revenue and cost curves, a monopolistic competition maximizes profit or minimizes loss by MR = MC.Long-run EquilibriumAttained when demand curve for each producer is tangent to LAC curve. Unrestricted entry / and exit lead to this equilibrium. At the equilibrium output, P = LAC and MR = LMC.Implementing the profit-maximizing output and pricing decisionGeneral rules of implementationThen:Multiplant firms* For a firm that produces using two plants, A and B, with marginal costs MCA and MCB, respectively, the total cost of producing any given level of total output QT (= QA + QB) is minimized when the manager allocates production between the two plants so that the marginal costs are equal: MCA = MCB.

* A manager who has n plants that can produce output will maximize profit when the firm produces the level of total output allocates that output among the n plants so that:

MR = MC1 = MC2 = ... = MCnDon't forget !Strategic behaviorActions taken by firms to plan for and react to competition from rival firms.OligopolyA market consisting of a few relatively large firms, each with a substantial share of the market and all recognize their independence.Decision making when rivals make simultaneous decisionsStrategic decision makingGame theoryAn analytical guide or tool for making decisions in situations involving interdependence.GameAny decision-making situation in which people compete with each other for the purpose of gaining the greatest individual pay off.Simultaneous decision gamesA situation in which competing firms must make their individual decisions without knowing their rivals’s decisions.The Prisoners's DilemmaArises when all rivals possess dominant strategies, and, in dominant strategy equilibrium, they are all worse off than if they had cooperated in making their decisions.Dominant StrategyWhen one exists, a rational decision maker always chooses to follow its own dominant strategy and predicts that if its rivals have dominant strategies, they also will choose to follow their dominant strategies.Decisions with One Dominant StrategyWhen a firm does not have a dominant strategy, but at least one of its rivals does have a dominant strategy, the firm's manager can predict with confidence that its rivals will follow their dominant strategies. Then, the manager can choose its own best strategy, knowing the actions that will almost certainly be taken boy those rivals possessing dominant strategies.Dominated StrategiesStrategies that would never be chosen no matter what rivals might choose to do.Successive elimination of dominated strategies In a simultaneous decision having no dominant strategy equilibrium, managers can simplify their decisions by eliminating all dominated strategies that may exist. the process of elimination should be repeated until no more dominated strategies turn up.Nash Equilibrium: Making mutually best decisionsSet of actions for which all managers are choosing their best actions given the actions chosen by their rivals.When managers face a simultaneous decision-makingsituation possessing a unique Nash equilibrium set of decisions, rivalse can be expected to make the decisions leading to the Nash equilibrium. If there are multiple Nash equilibria, there is generally no way to preodict the likely outcome.Best-response curves and continuous decision choicesA curve indicating the best decision (usually the profit-maximizing one) given the decision the manager believes a rival will make.When decision choices are continuous, best-response curves give managers the profit-maximizing price to set given the price they anticipate their rival will set. A Nash equilibrium occurs at the price where the firms'best-response curves intersect.Strategy when rivals make sequential decisionsSequential decisionsOne firm makes its decision first, then a rival firm, knowing the action of the first firm, makes its decision.Game treeA diagram showing the structure and payoff of a sequential decision situation.Decision nodesPoints in a game tree, represented by boxes, where decisions are made.Making sequential decisionsWhen firms make sequential decisions, managers make best decisions for themselves by working backward through the game free using the roll-back method (unique path that is also a Nash decision path: Each firms does the best for itself given the best decisions made by its rivals).First-mover and Second-Mover Advantages* First-mover advantage: a firm can increase its payoff by making its decision first.* Second-mover advantage: a firm can increase its payoff by making its decision second.* Roll-back method can be applied to the game trees for each possible sequence of decisions.Strategic MovesCommitmentsThreatsPromisesUnconditional actions taken for the purpose of increasing payoffs to the committing firms.Conditional strategic moves that take the form: "If you do A, I will do B, which is costly to you."Conditional strategic moves that take the form: "If you do A, I will do B, which is desirable to you".Cooperation in Repeated Strategic DecisionsCooperation occurs when oligopoly firms make individual decisions that make every firm better off than they would be in a (non cooperative) Nash equilibrium.One-time Prisoner's Dilemma DecisionsThere can be no future consequences from cheating, so both firms expect the other to cheat, which then makes cheating the best response for each firm.Punishment for Cheating in repeated decisionsMaking a retaliatory decision that forces rivals to return to a non cooperative Nash outcome.Deciding to CooperateCooperation (deciding not to cheat) maximizes the value of a firm when the present value of the costs of cheating is greater than the present value of the benefits from cheating. Achieved in an oligopoly market when all firms decide not to cheat.Trigger Strategies for punishing CheatingPunishment strategies that choose cooperative actions until an episode of cheating triggers a period of punishment.Tit-for-tat strategy: Punishes after an episode of cheating and returns to cooperation if cheating ends.Grim strategy: Punishes forever after an episode of cheating.Facilitating Practices Lawful methods of encouraging cooperative pricing behavior:* Price matching: A commitment to match any rival's lower price.* Sale-price guarantee: A firm's promise to give its buyers any sale price it might offer during a stipulated future period.* Public pricing: Informing buyers about prices in a way that makes pricing information public knowledge.* Price leadership: a leader firm sets the industry profit-maximizing price and the follower firms cooperate by all setting the same price.Explicit Price-fixing agreements and CartelsA group of firms or nations entering an explicit agreement to restrict competition for the purpose of driving up prices.Tacit collusionCooperation among rival firms that does not involve any explicit agreement.Strategic Entry DeterrenceStrategic moves taken by established firms to prevent entry of new firms.Limit pricing: An established firm commits to setting price below the profit-maximizing level to prevent entry.

Capacity expansion as a barrier to entry: Strategy in which an established firm irreversibly expands capacity to make credible its threat to decrease price if entry occurs.